Tuesday, 27 September 2011

Mutual funds in Canada have been under fire for their high fees and under-performance (hat tip to Canadian Capitalist). The industry body, the Investment Funds Institute of Canada has been attempting to shoot back at mutual funds' main competitor, ETFs. But its latest sloppy and slapdash salvo in the form of the July 2011 report Active and Passive Investing does more to discredit the IFIC and its cause than to help it. How so?

1) Consider the publication of the report itself. Is it secret or not?

Not Secret - Though I received a copy from Ken Kivenko of CanadianFundWatch.com (thanks, Ken) who forwarded the email attaching it sent out under the signature of IFIC CEO Joanne De Laurentiis.

Secret - The IFIC original email has the warning at the bottom "This e-mail (including attachments) is confidential and is intended solely for the addressee..." Oh really?

Not Secret - Why then does the text from De Laurentiis' say "It is the objective of the Report to clarify and counter misperceptions associated with active and passive investing so that research organizations and public policy makers can be better informed...". That sure looks as though it is intended to be publicly disseminated.

Secret - The IFIC website itself, however, seems not to show the report in any public area, only in a reserved members area (through this search link).

Not Secret - This secret public report meant to be used per De Laurentiis "... as a reference authority in materials developed by you (e.g., articles, reports, etc.)" can actually be accessed through (marvels of the Google and the Internet!) a link at the bottom of this post on Arbetov.ca.

On the whole the image one is left with is that IFIC is trying to feed ammunition to its membership of fund distributors and sellers to have numbers to quote to clients but that it does not want to release the report to wider public scrutiny, including skeptical bloggers!

2) The suspicion of devious intent gets stronger once one looks at the flawed report itself. Its basic approach is to show that passive investing can be expensive, done by trying to show that ETF costs are higher than many people think. However,

ETF does not equal passive investing (and the flipside is that Mutual fund does not equal active investing). The report throughout treats all ETFs as if they are the same as passive index investments. That might have been a fair generalization ten years ago but today ETFs have become very diverse. Many high cost, poor-quality, narrowly focussed ETFs have come on the scene, some even with explicit active strategies.

Mixing all ETFs together and calculating average costs raises the apparent cost of a passive index (i.e. a broadly based market-cap) strategy. Transaction costs, bid/ask spread and tracking error, which the report says add up to 1.2% ETF under-performance relative to index, is at most 0.1% for a fund like Vanguard's Total (US) Stock Market ETF (VTI) or the grand-daddy biggest-of-them-all SPDR S&P 500 (SPY). The true lesson is not that passive indexing is expensive, it is that today investors need to be just as careful picking ETFs as mutual funds. ETFs that are too small, too narrow and only sample stocks instead of replicating an index are prone to index under-performance from large tracking error.

The 1% that IFIC says goes to providing advice to mutual fund investors, which ETF investors do not get, and therefore causes ETF under-performance by that amount, rests on the dubious conclusion that investors get 1% worth of advice. The previous IFIC report The Value of Advice (which also seems to be hidden away in IFIC's website) it cites as evidence received a thrashing on its release in 2010 - e.g. see Canadian Capitalist's Readers Rip IFIC Report to Shreds.

Risk, as expressed in volatility, is not or should not be an end in itself, so for IFIC to state that actively managed funds offer investors the risk exposure they wish is beside the point. As books like Richard Ferri's The Power of Passive Investing, David Swensen's Unconventional Success and many others have repeatedly documented in great detail, actively managed mutual funds have performed poorly on a risk vs return adjusted basis. It doesn't help to take on risk if you lose in doing so.

As I said in my review of Ferri's book, the issue is not active investing vs passive investing in principle or in general, it is with the funds actually available to small individual investors and how they perform in reality. That's why I am currently testing the RAFI fundamental strategy, which I think is better in principle and has been shown to be so using (non-investable) index data, against cap-weight using actual ETFs available to investors. A key question is whether the higher fees on the RAFI funds overcome their theoretical advantage and give off lower net returns.

There is nothing wrong with mutual funds per se. I don't think that as a technical legal structure they are any better or worse than ETFs. The problem is simply that the current mass of available mutual funds suffer from too high fees that negate their value. They don't add enough value to earn their fees. This lackadaisical offering from IFIC doesn't inspire much respect or do much to help their cause.

6 comments:

As far as the disclaimer on the email goes, that's usually just a stupid IT policy. No one at my company can send emails to outside domains without a disclaimer getting attached. That includes, for instance, press releases.

As with many legal-ish disclaimers, waivers, etc, in our society, the disclaimers are not actually enforceable. Both parties to a conversation have to agree to confidentiality in order for it to be binding (an existing contractual relationship would apply, though).

As far as fees go, I've found that since my broker forwards all trailer fees into my account as if they were dividends, there's many actively managed mutual funds that end up cost-competitive with ETFs offering similar services. While it's by no means my whole portfolio, some subcategories (small caps, for instance) have been shown to benefit from active management that picks individual companies instead of just a broad index.

Excellent points! The mutual fund fees and expenses are the main reason why I do not use them, and have sold them all and use only ETFs.Two benifits of this:1. I understand what my money is invested in2. I am saving lots of money in fees, which translates to more money in my pocket.

Keep up the pressure on the mutual fund industry to lower the fees, expenses, and costs!

Neil, phew! Ken told me he is "worried" about getting a lawyer's letter from IFIC.

Pacific, me too, only ETFs for me but I'd be interested if an outfit like Vanguard started offering mutual funds like the ones they have in the USA. Who knows, now that they starting into the ETFs maybe mutual funds are next.